The cracks began appearing before the ink was dry. More worrisome is that the Greek leadership didn’t even believe they were on board in the first place. Simply put, the world economy is no less fragile than it was a week ago. And in that fragility still lies the recession risk for a still struggling US economy.

The referendum also looked likely to cause alarm in Brussels, Paris and Berlin after Mr Papandreou’s assurances at Wednesday’s summit that Greece was determined to maintain a steady pace of reform.

The reason for the alarm is that the Greek citizenry is not in favour of the bailout agreed to in Brussels last week. The FT reports that 60% of Greeks would reject the deal.

For Mr. Papandreou, this is certainly the right political call. He knows that austerity is deeply unpopular in Greece and risks a veritable civil war of social unrest. This particular bailout agreement is likely to be even more unpopular due to the permanent presence of the EU, IMF and ECB to ensure compliance with the approved austerity programs. From a political perspective it makes sense to put these measures to a referendum to ensure their political viability in an already volatile social environment.

The need to enhance the political legitimacy of these agreements is all the more necessary given the widespread perception that the EU apparatus is now seen by many Europeans as deeply undemocratic. For example, in Germany where anti-bailout sentiment is rife, many are aghast at the amount of money used to support the periphery economies in particular because the euro was never voted upon by the German electorate in a referendum. Another example comes from the present European Constitution, the Lisbon Treaty. Ireland voted ‘No’ on the Lisbon Treaty. Yet, inexplicably this vote was retaken in order to achieve passage. Many in Ireland believe this makes the current ‘Reform Treaty’ illegitimate.

Given Greek sentiment, in all likelihood, a referendum vote for the bailout agreement will fail. The question is “what then?” I would anticipate that, at a minimum, an actual default which triggers credit default swaps with higher bondholder losses is likely, crystallising losses across the European (and American) banking system. Greece and its banks would be insolvent.

At that point the questions would go to contagion. Italy’s re-coupling to the periphery is well-advanced, making it now the focal point of the sovereign debt crisis. Meanwhile, the euro zone has probably already started a double dip recession which will cause Portugal and other periphery economies to miss their deficit targets. There are, therefore, a number of other weak points were contagion could spread: to periphery sovereign bonds, to the banks of those countries, and to the banks elsewhere most exposed to them.

The ECB will be forced to intervene. However, the damage could still be done before it does so.

This post originally appeared at Credit Writedowns and is reproduced with permission.